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Ideology and the sources of policy error

Stephen Joske has an essay at War on the Rocks that makes a good point about the possibility of a Chinese financial crisis:

We commonly hear that China cannot have a financial crisis because the government owns all the banks and can control them. … In theory, government control is good for stability. In practice, however, two things have to happen to avoid a crisis: First, the government has to use its power to make the right policy choice, and second, it has to avoid making a Lehman-style regulatory mistake. …

While the government owns the banks, that does not stop officials from making regulatory mistakes. We have already seen regulatory mistakes such as mishandling of RMB market volatility in 2015. We have also seen well-handled, timely, and complex crisis management failing financial companies. But that does not mean they always handle every crisis well and will continue to do so. The law of probability indicates that eventually something will go wrong and, like every other country, China will have a financial crisis.

It is a fair point that humans are fallible and will eventually make a mistake, and we should not presume that the Chinese financial authorities are more or less fallible than all other humans.

But I think it is a bit of a cop-out to just say, oh, policy errors happen, and not to inquire more deeply into the actual causes of policy error. I think if we look at the recent history of financial policy mistakes, many them were in fact not driven by random errors but by ideology.

It is hard to separate the US policy errors in the global financial crisis from the strong ideological value placed on the government abstaining from intervening in markets. The day after Lehman Brothers failed, then-St. Louis Fed president Andrew Bullard said: “By denying funding to Lehman suitors, the Fed has begun to reestablish the idea that markets should not expect help at each difficult juncture.”

There would have been technical and legal difficulties to mounting a rescue of Lehman, but these could certainly have been surmounted if officials had been really worried about the impact of a failure on the financial system. They were not that worried (which in hindsight was clearly an error) and were preoccupied with sending signals about the correct relationship between the government and the financial system.

Most financial crises take the form of a “run on the bank,” even if the bank is not called a bank and those doing the running are not retail depositors. When investors no longer wish to hold bank liabilities, the bank cannot fund itself and experiences a liquidity crisis. But if investors know or believe that the government will rescue the financial institution, they are less likely to be so fearful of failure as to stop holding its liabilities, and less likely to fear that the problems of one institution will spread to others.

So a system in which the government is ideologically committed to maintaining a separation between the public sector and a private financial sector, and a system in which the government is ideologically committed to maintaining the union of the public sector and the financial sector, are not at all equivalent in terms of financial risk. In the former, there is much more of a risk that private investors will become worried about the failure of banks and stop funding them. (The latter, of course, has the problem that banks will tend to abuse government support and take more risk than they should.)

So it seems to me that, while Chinese officials are not more or less fallible than other humans, they do operate in a system that tends to minimize one major source of the policy errors that tend to lead to financial crises. Simply put, Chinese officials are more likely to err in favor of providing government support to a failing institution than in favor of denying it. This does not mean that Chinese banks cannot fail–it seems quite likely to me that some smaller institutions will eventually go under–but that such failures are much less likely to cause contagion and a crisis of confidence in the financial system.

Arguably Chinese financial policy is in fact less ideological than American. That may seem a strange thing to say about a system in which ideology is highly formalized and there is a large institutional structure for ensuring compliance with ideology. But the ideology of the Communist Party is inflexible only about ends, rather than means. Continuation of Party rule and its ability to direct social and economic development cannot be questioned.

But China is fairly flexible about the means employed to achieve those ends. American political ideology by contrast puts strong constraints on means: there are often intense arguments about why various things cannot be done or should be done in order to maintain the self-image of the US as a free-market economy.

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2 Comments

In China, ideology may cause the government to lean toward intervention. But that does not mean that the government is less likely to err, since it cannot be known ahead of time (in most cases) whether intervention will prevent or exacerbate contagion.

One can easily imagine circumstances in which rescue of a failing institution induces more institutions to fail in order to be rescued.

We simply do not have, in the East or the West, the understanding of financial interactions required to know, in most cases, whether support of a failing institution will prevent or exacerbate contagion.

I think the Lehman misstep was a case of incompetence more than ideological rigidity. The people at the political peak in America really are mediocrities for the most part. I also think China’s process of adding ever more deadweight debt to its economic train is driven by incompetence rather than ideology.